Diversification and Performance: Two Portfolios

Dan Egan

Managing Director of Behavioral Finance & Investing

In an all index-fund portfolio like Betterment’s, enhanced performance comes from finding and making the most of a diverse set of assets.

Originally published: December 20, 2013

KEY TAKEAWAYS

The Betterment portfolio has historically outperformed a DIY benchmark portfolio by as much as 1.8%.

Diversification alpha leads to better performance over time.

The investing world abounds with simple formulas for do-it-yourself investors—the simplest is a basic portfolio made up of two funds: one with stocks and one with bonds. A benefit to this ultra-simple portfolio is that it’s easy and time-effective to manage. (Even the father of Modern Portfolio Theory, Harry Markowitz, famously said he used a 50-50 stock-bond portfolio.)

But is this simple option truly the best for investors who value simplicity and their time, but want a better expected take-home return? Yes, a two-fund portfolio might be cheap and easy, but does it actually deliver the best return even after taxes, trading costs, etc.?

The answer is no. After analysis of the Betterment portfolio versus a standard DIY investor benchmark of a super-simple stock/bond portfolio, we show that Betterment came out clearly ahead during the period over which it’s possible to make a meaningful comparison. Our asset allocation delivers better risk-adjusted returns—and our automation delivers the ease and simplicity sought after by these thrifty investors.

Our asset allocation improves upon a simple DIY asset allocation in thoughtful and specific ways that boost risk-adjusted performance at all risk levels. Our asset allocation improves upon this standard DIY asset allocation in thoughtful and specific ways that boost risk-adjusted performance at all risk levels. As a result, the Betterment portfolio has historically outperformed a simple DIY investor benchmark portfolio by as much as 1.8% per year on a risk-adjusted basis.

We blend the best growth factors

Where did this extra performance come from? It’s smart asset allocation, or what is called diversification alpha. In our portfolio, we used a wider set of market and growth factors — like emerging markets and small-cap companies— and blended them together to create a whole which is greater than the sum of its parts.

Furthermore, all our strategic allocations are ones we are comfortable holding for a year or more, as matched by our recommended risk level. That’s a piece of our core investment philosophy as an index-based investment manager.

Comparing portfolios

We compared how $100,000 would fare when invested in the stock/bond benchmark, or so-called “naive portfolio ” against our 12-asset class portfolio. To be sure, it’s not comparing apples to apples in terms of assets—but it shows that for less effort (time, cost, energy), an individual investor can do much better by choosing a Betterment portfolio.

In the DIY portfolio, we used the S&P 500 and TIPS. This is the portfolio often recommended for a so-called “naive” investor who goes for the most commonly known stock market and bond funds.

Next, we compared three of the most typical stock allocations: 50% (a risk allocation recommended for shorter-term goals), 70% (the typical allocation), and 90% (our long-term recommended allocation). It’s important to know that our diversification alpha occurs at all points along the risk-level spectrum.

Betterment’s portfolio had significantly higher returns than the naive portfolio. While the Betterment portfolio did have a significantly larger drawdown in the financial crisis, previous gains meant that it was never worth less than the benchmark portfolios, even at the nadir of the financial crisis.

The value of diversification alpha

At the same stock allocation percentage, the Betterment stock funds are riskier than the naive portfolio funds. Does that mean the higher return is due to higher risk taking?

To control for this, we looked at risk-adjusted performance. To adjust for risk, we divide the excess return by the level of volatility the portfolio experienced. By doing this, we equalize portfolios that have higher returns purely because they have higher volatility. Any remaining return difference is due to diversification alpha.

With Betterment, you never need to settle for lower expected returns just because it’s simpler to manage. We offer the optimal index-based portfolio—which can be adapted for any level of risk—and manage it optimally for you, automatically.

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Dan Egan is the Director of Behavioral Finance and Investments at Betterment. He has spent his career using behavioral finance to help people make better financial and investment decisions. Dan is a published author of multiple publications related to behavioral economics. He lectures at New York University, London Business School, and the London School of Economics on the topic.
Contact Dan at Google+

13 thoughts on “Diversification and Performance: Two Portfolios”

While this is interesting, I’d really like to see a comparison of Betterment to something a bit more modern with the do-it-yourself portfolio. If you’re a Boglehead, most people use a 3 (or sometimes 4 or 5) fund portfolio consisting of the following funds:

How does Betterment compare to these? In theory these funds have more of what Betterment does, such as small cap and international, which should add to the long term returns of the do-it-yourself portfolio. Also, if you use a big company like Fidelity or Vanguard, you can trade some very low cost index funds for free.

Personally, I invest about one-third of my non-401(k) money in Betterment, and the other part in Fidelity in the following three funds: FSTVX, FSIVX and FSITX, which represent the necessary three classes of funds. I don’t pay for any trades, and the weighted average of my expense ratios is only 0.08%. There is a small amount of work I put in to rebalancing my portfolio once in a while, but I take a Betterment-like approach by trying to rebalance as I go with dividends and any deposits. Doing it that way I have never had to sell anything to rebalance.

Since I actually love Betterment, and don’t plan to take my money out of it anytime soon (despite paying more than 0.08% in fees), I would really like to see how Betterment compares in performance to a portfolio like I’ve described. Also, anybody who invests in target-date funds probably has a mix of funds like this, even if they don’t realize it, so this would apply to them to some degree as well (though target date funds have lots of other issues that aren’t related simply to performance at any given time).

Good points. Love to hearing feedback from savvy investors like yourselves.

We chose the S&P500 & TIPs as the naive assets because they are what an individual completely “naive” or new to DIY investing might choose. The media reports on the Dow and S&P500, so they’re what most people know, and will default to investing in. TIPS at least give the individual the aim of inflation protected returns, rather than credit or interest rate risk.

This is just a starting point. We will be following up with more analysis next year, looking at Betterment versus some of the portfolios you mention in your comments.

Curious why you’re using FIFO as your cost basis method. While it may increase the chance that lots sold have been held for over a year, would it not be preferable to defer these LT gains as long as possible?

Using FIFO does mean we’re most likely to book a long-term gain rather than a short term gain, reducing potential taxes (and vice versa – a long-term loss rather than a short-term loss). However, FIFO does not affect your ability to directly defer LT gains.

That said, we are researching some improved selling logic. Keep your eyes open next year.

I no ticed that your portfolio had the same percentage down draft as the naive portfolio in the 2008-2009 financial crisis. I would expect that with all the pains you take to balance a portfolio you would not include in it ETF’s which short the market or some other hedging methodology in order to alleviate the pain that can occur in a black swan event.Given our fragile financial infrastructure, this is almost sure to happen again.
Any comment?

You are correct that we don’t include ‘exotic’ ETF’s that use leverage or short the market.

Our portfolio construction is downside focused when it comes to risk (we’ll explain this further in an upcoming research article), and uses your investment horizon to ensure you’re taking on the right balance of risk. The result of our process is that it has higher risk-adjusted returns than comprable naive portfolios. When comparing them, we have to hold one variable constant; we can either compare two portfolios with the same return in terms of risk, or compare two portfolios with the same risk in terms of return (what we did in this analysis).

Having higher risk-adjusted returns means you are getting a better deal (return per unit risk) than you would otherwise, which also means we’re comfortable recommending a slightly higher risk level, since you’re likely to experience some of those higher returns before you experience a drawdown event.

For AGG, we don’t need to use the index as the ETF has been around since 2004.

Do note that when using index data we deduct the current expense ratio from the index returns to adjust for the fact that the index does not have the relevant ETF costs included.

Also, in all cases you have to use the total return (price return plus dividend return) to correctly assess performance. Be careful when pulling publicly available data that they include dividends. This is especially important for high yielding assets such as VWOB and BNDX.

I studied MPT quite a bit in the 90s and was fascinated by it. However, it doesn’t appear that there are ample negatively correlated asset classes for a solid implementation. That chart above scares the daylights out of me. It appears MPT provided barely any downside protection when needed most – 2008-2009 and summer 2011.

I agree that it would be nice if we could find negatively correlated assets, but don’t discount the value that non-perfectly correlated assets bring. As long as it persists after cost & fees, any additional diversification is good.

The reason the drawdowns look to be of roughly the same size is because they should be – we’ve selected two portfolios with equal levels of risk. The Betterment portfolio has higher expected risk-adjusted returns, and in order to show that visually, you have to contrast (a) the return of two portfolios, which have the same risk level (what we’ve done), or (b) compare the risk (drawdown) of two portfolios with the same return. If we were to compare a Naive vs Betterment portfolio with the same average historic return, the Betterment portfolio would have a smaller drawdown.

Unless otherwise specified, all return figures shown above are for illustrative purposes only, and are not actual customer or model returns. Actual returns will vary greatly and depend on personal and market circumstances.

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